RBA pauses in April as insolvencies pile up

The Reserve Bank of Australia has paused an almost yearlong tightening cycle as it assesses the impact of its 10 consecutive interest rate increases on households and businesses, and monitors headwinds facing the global economy.

It’s a welcome reprieve from the fastest tightening cycle in decades – which has seen the official cash rate surge from 0.1% to 3.6% in less than a year – but comes too late for a growing number of businesses.

Insolvencies wave hits

ASX-listed skincare brand BWX, which owns Sukin and has a controlling stake in Zoe Foster Blake’s Go-To Skincare, was placed in voluntary administration on Monday, just days after Melbourne-based home builder Porter Davis collapsed and construction firm Lloyd Group entered voluntary administration – adding to the more-than 5,000 Australian companies that have fallen into liquidation, receivership or administration since July 2022.

That’s more than the entirety of the previous financial year, when ultra-low interest rates kept the cost of debt low and temporary insolvency protections propped up companies during Covid-19 lockdowns.

Construction firms are driving the insolvency wave amid a perfect storm of higher material and labour costs, delays caused by rain and supply chain disruptions, slim margins, fewer new contracts as homebuyers get nervous, and rising interest rates.

Insolvency data from the Australian Securities and Investments Commission (ASIC) shows more than 400 construction companies have gone under since the start of the year, with the sector accounting for more than one in four – or almost 1,500 – insolvencies since July 2022.

Andrew Canobi, director of fixed income at Franklin Templeton says the collapse of Porter Davis, on the back of many construction firms struggling will have alarmed the RBA board.

"They will be increasingly worried that interest rate sensitive parts of the economy like construction are starting to break,” Canobi says.

RBA governor Philip Lowe acknowledged the impact rising interest rates are having on households and businesses, but said further rate hikes may be needed to get inflation back within its 2-3% target range.

“The Board’s priority is to return inflation to target. High inflation makes life difficult for people and damages the functioning of the economy,” Lowe said in his post-meeting statement.

“In assessing when and how much further interest rates need to increase, the Board will be paying close attention to developments in the global economy, trends in household spending and the outlook for inflation and the labour market.”

Credit to tighten

But could a looming global credit crunch do much of the heavy lifting?

Last week, US Federal Reserve Chair Jerome Powell signalled the central bank could pause rate hikes in April as tighter credit conditions weigh on inflation and hiring.

“Events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes,” he said.

Fears of a global credit crunch have intensified as rising interest rates prompted the collapse of several US banks, including tech-lender Silicon Valley Bank, and the hasty takeover of scandal-plagued Swiss bank Credit Suisse.

Unlike interest rates – which can take 12 to 18 months to fully flow through to the economy – the tightening of credit happens quickly and often without warning, says Kellie Wood, deputy head of fixed income at Schroders.

“We’re positioning for credit crunch, where we see a huge tightening of lending standards over the next three to six months, and this does the work for central banks,” Wood said during a media roundtable event.

“And that's when you start to see funding costs go up, corporates not being able to fund themselves in the market, or by a banking channel, because credit is tight, and people just step back from giving them funds. And that's when they reduce costs and shed their workforce, and that starts to happen quite quickly,” said Wood.

While home loan arrears remain near historically low levels, the jobs market is still incredibly tight. The RBA expects unemployment will start to rise as the economy slows.

For investors, holding onto highly speculative, unprofitable growth stocks in the current environment has been likened to buying a lottery ticket by investment strategists.

Like financial markets, Wood expects the RBA is done with interest rate rises. Economists remain split over whether the RBA will move again in May.

'Contagion risks' facing the building sector

No doubt, new headwinds have emerged for the RBA compared to its decision just a month ago, but there are some differences to the headwinds facing other central banks. Australia’s banking system remains strong, and lenders continue to battle for new customers – albeit for high-quality borrowers with a low loan-to-value ratio.

The escalating rate of collapse of home builders and construction firms in Australia cannot be ignored.

In its latest financial stability review, released in October, the RBA included a chapter on the ‘financial stress and contagion risks’ in the residential construction industry, noting a sharp increase in insolvencies, which now exceed pre-pandemic levels.

“While the direct implications for the financial system are limited because banks have very small exposures to builders, there is potential for financial stress to spread to other businesses within the broader construction industry and to some households,” the review said.

With construction accounting for close to 10% of total employment in Australia, many household borrowers depend on the construction industry to some degree.

“Furthermore, those households currently building a new home are exposed to the industry and are likely to have mortgages with banks.”

The RBA will release its next financial stability review on Thursday.